Monday, October 24, 2011

Can Knut Wicksell Beat Up Chuck Norris?

Nick Rowe argues that NGDP targeting is a way of dealing with coordination failure. Businesses don’t want to hire if nobody’s buying, and households don’t want to buy if nobody’s hiring. So they’re all hoarding money instead. The way to fix it is that you have Chuck Norris threaten to beat up anyone who hoards money. Then businesses start hiring and households start buying (or else they both buy riskier assets, and the people who sold those assets do the hiring and buying, because they also don’t want to be beat up for hoarding the proceeds).

In the simplest version of the argument, beating people up is a metaphor for inflation. But if you don’t believe the Fed can produce more inflation (as many economists believe that the Bank of Japan has tried and failed to produce a positive inflation rate over the past 20 years), you can take beating people up as a metaphor for reducing asset returns. Even if the Fed can’t produce inflation, it can bid down the returns on a lot of assets until people get fed up and start buying riskier assets that can finance new expenditures. Some people don’t even think the Fed can do that, because maybe people have such a strong need for safety that they will only hoard more cash if other safe asset returns go down. I’m not 100% sure myself, but, for the sake of argument, I’m going to assume that the Fed can, if it is aggressive enough in buying safe assets, convince people to buy enough risky assets to get the economy going again.

Nick’s point, though, is that the Fed can do this without actually reducing the return on safe asests (and presumably without producing a lot of inflation either). Chuck Norris can clear a room without actually beating anyone up. The threat is enough. Similarly, in Nick’s view, the Fed can fix a coordination failure by threatening to reduce the return on safe assets, but it won’t have to carry out that threat if it’s credible. In fact, asset returns will go up, because the improved economy will make businesses more profitable, thus raising the return on risky assets and inducing people to abandon safe assets even if the yields go up. Paradoxically, by credibly threatening to push asset returns down, the Fed succeeds in pushing them up.

OK, fine. I’ll note that Ben Bernanke is no Chuck Norris, but perhaps President Romney will replace him with Chuck Norris, or with the antimatter counterpart of Paul Volcker (who was the Chuck Norris of inflation fighting). I’ll also note that Chairman Norris will enter with a considerable handicap, given that many are uncertain about the Fed’s ability to succeed in convincing people to abandon safe assets. If the threat were credible and everyone knew it to be credible, then everyone would know that stock prices are going up and they really ought to sell their bonds as quickly as they can, and we’d immediately be on the path to the good equilibrium. But even with Chuck Norris as Fed Chairman, a lot of people are going to think, “What if the Fed fails? At least cash is safe.” The threat alone quite possibly won’t be enough: Chuck Norris may well have to beat up a bunch of people – QE, Walker style – before the room clears.

But OK, I’m not opposed to violence, when it’s the only way to get something done. Only here’s my concern: how do we know that coordination failure is the real problem?

Flash back to 2006. There was no coordination failure then. Firms were hiring. Households were buying. Commerce was functioning smoothly. Very smoothly, too, in the sense that the economy was neither overheating (no rising inflation, no labor shortage) nor driving interest rates abnormally high. (The 10-year TIPS yield ranged from 1.95% to 2.68% in 2006, consistently below the perceived long-run real growth rate of the US economy.)

Yet that smoothness was based on being completely out of touch with reality – or at least out of touch with what most people today regard the reality to have been. By most accounts, housing prices were inflated, making people feel wealthier than they really were, and lots of seemingly safe assets were available, which, as it turned out, were not at all safe. Even with interest rates relatively low, this deception was apparently necessary in order to get households to buy and firms to hire in sufficient quantities to achieve full employment. Since the deception is no longer feasible, interest rates will presumably have to be a lot lower – even if we rule out coordination failure – in order to induce enough buying and enough hiring today to achieve full employment.

But how much lower? We can’t say exactly. Today 10-year TIPS are yielding close to zero. Is that low enough, if it weren’t for coordination failure? Maybe. Maybe not. Your guess is as good as mine. I can certainly imagine that could we fix the coordination failure (if there is one) and still end up producing well below our capacity.

That’s where Knut Wicksell comes in. Wicksell was the early 20th century economist who argued that prices would tend to go up or down depending on whether the interest rate was below or above its “natural” level (which varied over time). Modern interpretations allow for sticky prices and wages, so instead of falling prices, you get unemployment when the interest rate is too high. As I suggested in a post last year, and in the paragraph above, the “natural interest rate” could be negative, in which case a higher inflation rate is the only way to achieve full employment.

For practical purposes I advocate the same policy that Nick does – nominal GDP targeting – but I’m a bit less optimistic about how quickly and smoothly we could approach the target. And, given a choice, I’d probably favor a more aggressive target than Nick would. One of the implications of the Wicksellian analysis (which is not so clear if you think coordination failure is the only problem) is that more aggressive targets are easier to hit, because they imply higher inflation rates and therefore a lower floor on the real interest rate.

The important thing is to set a target path and stick to it even if you keep missing the first few targets by larger and larger margins. If the natural interest rate is negative, the early targets may be impossible to hit, but if you continue trying to hit the subsequent targets, those targets will imply higher inflation rates. Suppose your target path rises by 5% per year. A 10% increase in NGDP over two years may not imply enough inflation to get the real interest rate down to its natural level, but if NGDP doesn’t rise at all in those two years, the target path will now imply 20% NGDP growth over the subsequent two year period. That would require a lot of inflation – certainly enough to be consistent with a very negative natural real interest rate. Chuck Norris may take his hits in the first few years, but Knut is eventually going down.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

The natural rate of interest, as conceived by Wicksell, is the rate that results in stable prices (or in the neo-Wicksellian version, a stable inflation rate without cyclical unemployment). If price and wage adjustment were instantaneous and the money supply known in advance, presumably the actual interest rate would equal the natural rate without active policy. If prices and wages are sticky, then active policy has to offset changes in money demand to make the actual interest rate equal the natural rate.

Yep. With a level path target (either P or NGDP) Chuck commits to keep on fighting indefinitely, and fighting for a bigger and bigger prize as time goes by. Eventually Knut gets distracted, and the IS will shift right of it's own accord anyway, so the Fed can hit any NGDP or P level target it likes, even with conventional means.

In the arguments over Chuck, critics have ignored the time dimension. It cannot be a rational expectation to believe that Chuck will never win.

I don't see why we should be confident that the IS will shift right of its own accord. Knut will eventually get knocked down, maybe end up in the hospital for a while, but he may come back for a re-match.

Pre-crisis, the Fed could move the policy rate almost entirely by threat as opposed to actual OMO – because the threat was super credible. The reason the threat was super credible is that the demand for reserves was so super inelastic at the policy target rate (pre-crisis). The sensitivity of market rates to excess reserve changes was incredibly high. In other words, it took a very small action in terms of quantity of excess reserves with OMO - so the threat without OMO was very credible.

I don’t see that with the threat of QE. The scale of required operations in the absence of the threat is too huge. In terms of sensitivity, it is the polar opposite of targeting the overnight rate pre-crisis. Massive operations in the absence of a threat are required – to the point of buying up the entire stock of financial assets in some versions of the story. So the threat is not credible, simply because of scale, and because of the unknown, unintended consequences of intervening on such a scale. Scale is proportionate to risk of unimaginable types. So the threat would not be credible simply because risk management would not permit it.

How does the Fed apply the brakes once inflation hits 10-20%? Isn't there a self-reinforcing dynamic at work at that point? It seems to me the required jump in real rates would shock the economy.

I have trouble seeing how you move from a strongly negative natural rate (one equilibrium) to a solidly positive one (the next equilibrium) without a market dislocation. Arguably, we had just such a dislocation after the last tightening cycle. This happened because stimulus produces "lumpy" inflation -- price distortions that create friction in the economy.

If the target NGDP path is ongoing, then agents should anticipate the subsequent slowdown and moderate their wage and price demands. Presumably you wouldn't, for example, get labor contracts that called for large wage increases in the subsequent years, because everyone would know that the Fed intended to tighten. So, to the extent that expectations are rational, it shouldn't require much actual tightening.

The bigger problem I see is that the natural interest rate may still be negative, so you might get a new recession in spite of having little actual tightening. In theory, if the growth rate of the target path is too small, you get an endless series of cycles in which Chuck and Knut keep repeating their bout.

Andy,I think its more complicated than you imply. Inflation doesn't go to 10% and fall to 2% because the Fed wants it to. It has to tighten. When to begin? Linearly, incrementally, as inflation rises, or in one fell swoop when the NGDP level target is met? Are there examples inflation falling from 10% to 2% without a recession brought on by high real rates?

I think my point is that the concept of two equilibria may be logically consistent, but I'm not sure the model explains how we get from one to the other.

I thought that was the easy part. Do what Volcker did in 1979-1981. Raise interest rates. Workers have already been traumatized, the unions have been virtually destroyed, wages are no longer indexed, it shouldn't take such heroic measures as Volcker had to employ. I haven't been able to figure out why people don't see that. At the same time I don't understand why people keep saying low (zero) interest rates will "encourage" investment. All they have to do is look around them. Back in the 1930s they saw the obvious. "You can't push on a string."

They have to be low relative to the natural interest rate. In general, periods like the present (and the Great Depression and Japan's Lost Decades) are periods when the natural interest rate is unusually low (probably negative in real terms and maybe in nominal terms too). But consider this: if you could get the interest rate down to negative 100%, it would certainly encourage investment, because people would have to invest their wealth in real assets in order to avoid having it confiscated. So there is a natural interest rate somewhere between negative 100% and maybe positive 5%. Hopefully closer to the latter, but who knows?

Andy,What if there are two equilibria: a natural rate of -10%, and a natural rate of +2%. The question is, how do you move from one to the other given that no intermediate point represents an equilibrium? The easy answer is, jack up real rates by 14 percentage points when the economy nears the upper equilibrium. The problem is that this would shock the economy back into the lower one. Rinse, repeat.

I don't understand your last example. If there's an equilibrium with a positive natural interest rate, you can stay there just by keeping the interest rate there (unless there's deflation). And usually the equilibrium with the highest natural interest rate is the best equilibrium. The situation that's problematic is when both equilibria (or the one unique equilibrium) have negative natural interest rates. It's still not a problem if the inflation rate is high enough, but if you do level targeting and the implied inflation rate is too low, you end up with cycles because you can never keep the actual interest rate down at the natural rate once the price level (or NGDP) catches up with the target path.

1) First of all, let’s look not at the natural rate of interest, but at the natural level of borrowing, and try to estimate it from the Flow of Funds data (about 15% of GDP for 2004-2006).

2) Then, let’s define a sustainable level of long-term debt -- public and private -- based on the political realities, LTV for mortgages and other factors (about 200% of GDP -- where I exclude corporate debt , since for corporations net borrowing is about zero).

3) Now, we can find a steady-state solution for the NGDP growth rate where the debt-to-GDP ratio remains at the sustainable level (a 7,5% NGDP growth rate, a 5% inflation rate and -- if you plug the inflation rate into the classic Taylor rule -- a minus 1% real interest rate).

This steady-state full-employment solution is not terribly far away from the current high-unemployment state; so, theoretically, the US might be able to get there using only monetary policy – setting a higher inflation target and keeping long-term nominal rates at the current level by managing expectations and buying more long-term assets . That’s good news.

The bad news is that monetary policy in a high-inflation, negative-real-rates environment may be very tricky.

First, it is hard to see any kind of Phillips curve in the recent inflation data. It looks like core inflation is now determined mostly by expectations -- and to a smaller extent by rents and commodity price feedthrough -- and it is not clear how you can reliably re-anchor expectations at a different level.

Second, in a negative-real-rate environment, asset prices may become much more volatile (just think of doing any NPV-based valuation when the risk-free real rate is negative). This effect is bad in itself, but combined with commodity speculation and the commodity price feedthrough, it will make monetary policy even more difficult.

So, yes, NGDP targeting and a higher inflation target may be a good idea in principle; but, in order to make it work, we may need to overhaul the entire system of financial regulation, and learn to manage inflation without a strong Phillips-curve type relationship between inflation and unemployment.

This is very well written and gets at the goals of NGDP targeting quite well.

This is where I have problem with the whole idea. Its supply side madness writ large.

For me it starts with this;

"and households don’t want to buy if nobody’s hiring"

?.... When does a consumer EVER make a decision to buy based on whether businesses are hiring? You base it on 1) DO I need it 2) DO I have the money for it and then 3) If I dont have the money can I borrow the money

Now businesses certainly decide whether to hire based on the number of people they see coming through their doors but the converse is NOT true.

Seems to me if this is a starting point for making policy it will have to fail because it is starting in the wrong place. Its like Chuck Norris showing up at the party and the building is empty.

"When does a consumer EVER make a decision to buy based on whether businesses are hiring?"

At the very least, when that consumer is the one being hired (and was previously unemployed or about to be). I think more generally, even among those already employed, they consume more when they are more secure in their employment, and they will be more secure if there is more hiring going on (both because this is perceived to be correlated with less layoffs and because it would be easier to find a new job). And surely the purchasing decisions of the unemployed are influenced by their perceived prospects. If nobody's hiring, and they aren't getting any interviews, they cut back spending more drastically than if it looks like they might get hired soon.

You really make it seem so easy with your presentation but I find this topic to be really something which I think I would never understand. It seems too complicated and very broad for me. I am looking forward for your next post, I will try to get the hang of it!

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About Me

I’m an economist specializing in macroeconomics, with particular interests in labor and finance. Since finishing my doctorate at Harvard University in 1994, I have been involved in a number of projects related to economics, including writing econometric software, developing quantitative methods to forecast US Treasury yields, and co-authoring The Indebted Society with James Medoff. My occasional writing has appeared in various publications such as Barron’s and Grant’s Interest Rate Observer. Currently I am Chief Economist at Atlantic Asset Management. Opinions expressed here (as well as any errors or omissions) are entirely my own and do not necessarily reflect those of Atlantic Asset Management or its officers.

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